EC 108 Investment Summary

Investment

● Investment is the accumulation of physical capital
○ Physical capital is tangible assets used in the production process
● 3 types of investment:
○ Business fixed investment - business’ spending on equipment for
production
○ Residential investment - purchases of new housing units
○ Inventory investment - the value of the change in inventories
■ Negative inventory investment means you are selling goods that
were produced last year (running down the inventories)
● Investment occurs to bring the capital stock to the desired level and to make
up for depreciation
● Investment decisions depend on:
○ Current sales
○ Real interest rate
○ Expectations

The optimal stock of capital

● The marginal productivity of capital (MPK) is the amount of extra output that
can be obtained when an additional unit of capital is installed
○ Assumption of constant labour
● Y = AF(K,L)
○ A - technology
● MPK = the first derivative of Y = F(K,L) with respect
to K
○ = slope of production function
● The opportunity cost of 1 unit of capital is
1+r
○ The total cost of capital is (1+r)K
○ Investment is negatively related to
the real interest rate
● Profits after investment = F(K,L) - (1+r)K
○ Shown by the vertical distance
between the 2 curves
○ To maximise profits, firms aim to
maximise this vertical distance
○ Occurs when the slope of the
production function = the slope of
the total cost of capital
○ MPK = 1+r